RECURRING FINANCIAL CRISES

Reasons of Financial Crises

Financial instability is defined in the context of this paper as a failure of the financial intermediaries to perform their basic function of channeling funds from saving to investment and consumption in order for modern economy to function efficiently. The lack of needed information to make sound decisions in order to grant loans will push financial instability into financial crisis. The causes of financial crisis are lack of proper information, decline of credit availability, loans denominated in foreign currencies, depreciation of exchange rate, current account deficit, and lack of effective regulations.

Lack of Proper Information:

Market failure as a result of asymmetry of information is larger in asset markets than in goods and services markets. The asymmetry of information is pronounced in the international capital markets due to differences in cultural and legal frameworks. The asymmetry of information leads investors to react in panic to any sign of economic trouble by withdrawing their financial capital, pushing the country into financial crisis. The cost of acquiring information on a particular company in a given country reduces the rate of return on investment and, therefore, leads investors to behave like a herd in investing or withdrawing producing a boom-bust cycle according to Keminsky and Schmuckler (2002). Investors are aware of the fact that the longer they hold their assets during the financial crisis, the larger their losses will become, so they tend to overreact and produce market failure which may not be justified based on the actual fundamentals of the economy.

Asymmetric information is where the borrower has superior information compared to the lender. This asymmetry of information allows for the selection of high risk projects due to the willingness of the borrower to pay higher interest rates relative to less risky projects on the loan. This may prove to be the wrong strategy. The selection of high risk projects to finance and moral hazard problems lead lenders to lend less than what is optimal to be able to protect themselves. A moral hazard occurs if the borrower spends the loan, not for its original purpose but on activities that make the ability of the borrower to pay back the loan less likely. Also, imposing restrictions on loans are costly to monitor and enforce by the lender. Financial intermediaries’ ability to cut future lending to a given borrower may improve the borrowers’ behavior. International financial institutions and foreign banks use this method to impose restrictions on developing countries to change their fiscal, monetary, trade and investment policies.

High interest rates and access to long-term loans are problems constraining small and medium sized enterprises’ (SME) ability to expand. While global corporations finance higher percentage of their investment from commercial banks relative to SME, global corporations have the ability to access credit in many countries and the ability to borrow at a lower interest rate than SME as well as the access to long-term loans (see El-Mefleh 2002b). Also, lack of modern legal and financial development in a country may lead local firms to choose global banks for their services as in the case of Eastern European countries according to Berger, Dai, Ongena and Smith (2002). Banks, especially foreign banks, are hesitant to supply credit to SME because of a lack of information needed to assess the risk.

Credit Conditions, Illiquidity and Loans Denominated in Foreign Currency:

The financial crisis of Korea (1997) was the result of local firms borrowing from abroad. The firms exposed themselves to the risks of the international financial capital market. When doubts surfaced about Korea lack of foreign reserves needed to pay off their loans, banks decided not to renew their loans to Korean firms. The absence of loans to Korean firms triggered financial crisis, according to Stiglitz (2002).

Developing countries under the pressure of financial flight typically adopted drastic measures to stop the dramatic decline in exchange rates. One of these measures is a higher interest rate. The higher interest rate and depreciation of the currency increases the burden of local firms with debt denominated in foreign currencies and consequently leads to financial crisis and recession. One would expect that a high interest rate would require expansionary fiscal policy to offset some of the negative impact of contractionary monetary policies. This option was not viable for developing countries to use in order to avoid speculative attacks and maintain credibility with the market as was the case in SEA, Mexico, and Brazil. Contractionary fiscal and monetary policy in the face of recession will increase unemployment and induce a severe recession.

Increased uncertainty about the future economic conditions due to recession or failure of large corporations or the direction of fiscal and monetary policies may tend to reduce the lending activities of financial institutions. Stock market decline or deflation will reduce the market valuation of the net worth of the firms or the collateral which will reduce lending and, consequently, economic activities.

Capital account liberalization in the early 1990s was not needed in SEA countries due to their high savings rates, which were capable of financing their investment needs. However, capital account liberalization brings risks for a country even if the country has a sound banking system as well as well-developed stock markets. The sudden and substantial outflow of funds may create financial crisis and deep recession in developing countries. Firms in the U.S., Japan and Europe rely on selling shares in companies to raise new funds, while most developing countries rely on debt. Relying on debt to financial investment is a risky venture. But relying on retained earnings is not a sufficient instrument to raise needed financial capital for investment. Therefore, developing countries have to rely on borrowing for investment.

Illiquidity measure is the ratio of short term debt in foreign currencies to total foreign currency reserve in the hands of the central bank. A high illiquidity ratio is an indication of a central bank’s inability to easily cover short-term foreign debts using its foreign currency reserve. The other measure of illiquidity is the ratio of money supply (M2) to the central bank reserve of foreign currency. The high ratio of M2 to the central bank reserve of foreign currency indicates a potential problem if residents become concerned with the stability of their currency and want to convert their local currency into foreign currency. The high ratio of M2 to the reserve of the central bank would make it impossible for the central bank to honor that demand at the going rate before the panic. A high degree of illiquidity can make countries vulnerable to financial crisis. The sudden cut of lending to under-developed economies by international lending financial institutions can cause an economy to go into financial crisis as was the case for Korea in 1997.

Current Account Deficit:

According to Mishkin (1999), the Brazilian crisis was a balance of payments crisis which resulted from fiscal policy. But fiscal policy was not the cause of the financial crises of Mexico or South East Asian (SEA) countries. Fiscal deficit before the start of the crisis was .7% of the GDP in Mexico which was very small, while Thailand, Korea, Malaysia, Indonesia, and the Philippines had a surplus. Therefore, the fiscal policies of these countries were not the cause of their financial crises. Inflation was less than 8.5% in all of the above countries before the crises, which implies appropriate monetary policies. During the three years before the crisis, appreciation of currency was -1.1% for Korea, 2.1% for Malaysia, 2.9% for Indonesia, 7.6% for Thailand, 8.5% for Mexico, and 9% for the Philippines. Earlier real appreciation of currency may have contributed to the crisis in Mexico, Philippines, and Thailand, but did not contribute to the others. All of these countries experienced large current account deficits between 3.4% and 8% of their GDP. These deficits played an important part in creating the crises. Most developing countries face chronic current account deficit. Current account deficit without surplus capital account will create a depreciation of the currency under floating exchange rate or balance of payments crisis under fixed exchange rate.

Exchange Rate and Speculation:

Unexpected depreciation of a currency, which has little impact on the balance sheet of the local firms in industrialized countries, has a significant impact in precipitating financial crises in developing countries (see El-Mefleh 2003). Thailand’s financial crisis started with speculators who believed that Thailand’s currency would be depreciated. The expectation of depreciation of the currency led speculators to sell the local currency in exchange for foreign currencies. The government tried to support their currency by buying it up with their foreign reserves. When the government ran out of foreign reserves, the currency of Thailand plummeted. The depletion of official reserves or central bank actions to reduce interest rates can produce an abandonment of the fixed exchange rate. The reduction of interest rates would reduce the cost of public debt, strengthen the banking sector, and reduce the possibility of having to bail out the weak financial institutions, according to Kaminsky, Lizondo and Reinhart (1998).

Lack of Effective Regulations:

Lack of effective regulations and premature financial liberalization before the establishment of proper regulatory body was the reason behind financial crisis in developing economies. Stiglitz (1994) argued that interest rates on deposits should not exceed the treasury bill rates to prevent banks from competing for deposits to finance risky ventures, especially when the banks are on the verge of collapse.

Malaysian regulations in early 1997, which prevented banks from borrowing in foreign denominated currency, spared their banks from the danger of currency depreciation later. The limitation on companies’ ability to borrow from outside Malaysia helped their firms deal effectively with a later currency crisis. The regulations of 1998 helped Malaysia deal successfully with its financial crisis. Some of these regulations are interest rate cuts, limits on financial capital outflows, a temporary freeze on the repatriation of foreign financial assets and exit taxes on financial capital for a year. These regulations helped Malaysia stabilize their economy faster than other countries in similar circumstances in that part of the world.

Process of Financial Crisis

Inflation, deficit spending, and appreciation of the exchange rate did not exist and therefore, was not the cause of the financial crises in Mexico and the SEA countries. But current account deficits, illiquidity problems associated with lending expansion that had been financed by financial capital inflow, and the deterioration of financial institutions’ balance sheets were the apparent culprits behind the financial crisis of each country.

Before a financial crisis materializes, there is a currency crisis. The financial liberalization on interest rates, lending, foreign investment, as well as fixed exchange rates, usually leads to financial capital inflow due to high interest rates. The expansion in lending without proper management training, lack of sufficient knowledge in risk assessment tools on loans, and the existing weak financial regulations leads to excessive risk-taking by local financial institutions (see El-Mefleh 2003). Depositors and investors that were behind the financial capital inflow perceived their funds to be safe because of fixed exchange rates and the implicit safety net of the government and the IMF. Fixed exchange rates may encourage risk-taking behavior by the financial institutions and investors. The excessive risk-taking leads to loss and deterioration of the net value of financial institutions and, consequently, produced insolvency and reduced lending which in turn creates a credit crunch and pushes the economy closer to financial crisis. The decline of stock markets before or during the financial crisis creates more uncertainty in the market. Also, if during the time leading to the crisis, a major financial or non-financial corporation fails, uncertainty is increased (SEA and Mexico). All of the above creates the proper circumstances for financial crisis in developing economies, where loans are short-term and many of them denominated in foreign currency.

The short term loan contracts and their denominations in foreign currencies moves the currency crisis into financial crisis in the following manner. The devaluation of the currency increases the debt burden of domestic firms (especially in Indonesia where devaluation reached 75%), that had foreign debt denominated in foreign currencies. The devaluation reduces the net value of the financial institutions creating banking crisis. The devaluation reduces the ability of households and firms to pay their debt and, consequently, reduces the assets of the financial institutions. Also, devaluation of currency increases the liabilities of financial institutions because the inflow of foreign funds comes as short term loans denominated in foreign currencies. The decrease of financial institutions’ assets and the increase of liabilities combined with short term loans denominated in foreign currencies create a liquidity problem for the financial institutions. This insecurity with banks’ viability may create panic forcing many financial institutions to close their doors. Additionally, the devaluation of currency in developing countries increases current and expected inflation, which increases nominal interest rates, weakens some firms and bankrupts a large number of local firms.

The weakness of financial institutions, the high degree of illiquidity, speculative attacks and the inability of the central banks of developing countries to defend the currency may result in currency crisis as was the case for Mexico and the SEA countries. According to Gourinches and Jeanne (2002), tax on capital should not induce liquidation or outflow of funds as long as net rate of return on capital is larger than proceeds of liquidations of capital. Martin and Rey (2002) showed that if there is a symmetric liberalization of financial capital of a two-country model, where one of these two countries was high income and industrialized and the other country was mid-level income, the investment and income of the mid-level income country will increase. But also, pessimistic expectations can lead to financial collapse of the mid-level income country. The financial collapse would lead not only to financial capital flight but a decline of investment and income below financial autarchy level.

The contractionary fiscal and monetary policies of developing countries were a pre-condition for loan approval from the IMF. These contractionary policies are intended to solve budget deficits and increase interest rates to stop the decline of exchange rates (see El-Mefleh 2002a for more details). This process of restructuring increases the number of firms unable to pay their debt. Krugman (1999) argued that conventional fiscal and monetary policy instruments for fighting recession or financial panic in a stable, large and self-sufficient economy may not be viable or available to a developing country.

The financial crisis in developing countries leads banks to increase interest rates and to reduce their lending to achieve capital adequacy ratios. By reducing loans, firms must reduce their production, thus reducing income and increasing unemployment rates, which leads to a reduction in profits for some firms and bankruptcy for other firms. The bankruptcy of some firms worsens the balance sheets of the banks, leads to a further reduction in lending, and starts a new vicious cycle. This vicious cycle may push some banks into collapse. The collapse of any bank reduces the available information about creditworthy borrowers. These creditworthy borrowers may have a difficult time finding alternative suppliers of funds, especially in developing countries. Therefore, creating effective financial regulation is a worthwhile goal to pursue.

The depreciation of currency increases the volume of exports, but firms need working capital in order to expand their production. If banks reduce their lending, then production will decrease instead of expanding.

Signs of a Future Financial Crisis

The outflow of funds occurred when the crisis started. Some argued that the outflow of funds was the reason for the crisis rather than the symptom. The lending activities grew at a rate of 17%-30% annually during the three years before their financial crisis. These lending activities are a good predictor of future financial crisis according to Kaminsky (1999). Therefore, the deterioration of the balance sheets of these countries’ financial institutions due to nonperforming loans was the major cause of the financial crises of these countries.

There are many signs of financial crisis. The value of the short-term liabilities (loans) owned by foreigners relative to the total short-term debt, is one measure of vulnerability. These loans have a maturity of one year or less (you can get the number from the bank of international settlement.) Increased spending, real appreciation of domestic currency, increased current account deficit, and occasional increases in foreign debt are additional good predictors of future financial crisis. Then small events may trigger panic and financial crisis.

Another sign, financial liberalization, may provide financial capital inflows, credit and appreciation of the currency. When the economy enters into recession, banking crises appear and then lead to currency crisis. Banking problems usually start with a decline of asset quality by bankruptcies of firms in non-banking sectors or by a substantial decline in real estate prices. According to Kaminsky and Reinhart (1999), the probability of currency crisis increases within 24 months of banking crisis. A weak banking sector reduces the ability of the central bank to defend the currency. The peak of banking crisis comes after the currency crisis. The central bank fights off speculative attacks on the currency which leads to higher domestic interest rates and a depletion of foreign exchange reserves. External factors such as an increase of the interest rate in the U.S. in the early 1980s led to currency crisis in countries with foreign debts denominated in dollars. Banking crisis increases the probability of financial crisis and may lead to the devaluation of the currency. The devaluation usually increases the severity of the banking crisis. The severity of currency crisis can be measured by the real depreciation of the currency and the losses of foreign reserves. Financial liberalization, deregulation of the financial system, consequences of boom-bust cycles, and the bubble in asset values are some of the major reasons behind banking crisis.

The ratio of M2 to reserve gives an indication of the ability of the central bank to convert domestic deposits into foreign currency during a currency crisis. The ratio of M2 to reserve increases above the normal level during the year before a banking currency crisis due to an increase in M2 and a decline in foreign currency reserves. Credit expansion before the banking crisis is associated with a very positive growth of GDP. The debt problem of businesses and households becomes a problem as the economy enters in recession. A balance of payment crisis can be the result of a deterioration of terms of trade. The deterioration of balance of payments may produce a banking and currency crisis. But usually, balance of payments crises are associated with a huge sudden loss of reserve and the abandonment of the fixed exchange rate. The decline in export performance, deterioration of terms of trade, and appreciation of the currency are associated with the period before the banking crisis and currency crisis. The appreciation of the currency prior to these crises decreases the profit margin of local companies, increases bankruptcies in the non-financial sector and, consequently, increases banking sector problems.

The equity market performance starts to deteriorate during the year before the start of the crisis. The deterioration of the equity market performance leads to foreign financial capital outflow, deterioration of the economic performance and the collapse of real estate prices

Before a currency crisis, one would observe a gradual decline in official reserves and an expansion of domestic credit at noticeably higher rates than the trend. However, the expansion of domestic credit can be the result of a budget deficit or the bailout of troubled domestic financial institutions by the central bank. The loss of official reserves would trigger higher domestic interest rates. The expansion of domestic credit would trigger higher wages. Also, before any currency crisis (speculative attack) there would be a real appreciation of the currency and a deterioration of current account. Expectation of financial collapse would lead to higher interest rates and the prediction that the government would abandon the fixed exchange rate.

The self-fulfilling crisis is harder to predict because there are not any economic factors that can be used as predictors. Contagion can be another reason for currency crisis where the devaluation of the currency of one country may lead to the devaluation of currency in other countries in order to keep relative competitiveness intact. Contagion can be the result of investors pulling their financial assets from country A as a reaction to weak economic fundamentals in country B. Investors may interpret currency crisis in country B as a predictor of a future currency crisis of country A. The ability to predict potential currency crisis and its timing gives policy makers the ability to use instruments to avoid the financial crisis at best or at least lessen the crisis damage. Perfectly accurate predictions may not be possible to achieve, but understanding the warning signals is a worthwhile goal to pursue.

Remarks

Chile during the 1990s used control on financial capital inflows while Malaysia used control on financial capital outflows temporarily in 1998. Private sectors historically escape financial capital regulation by overpricing imports and under pricing exports. Financial capital mobility is always larger than the intended regulations, and in most developing countries there is a weak correlation between savings and investment.

When there is balance of payment deficits, control of capital outflows appears in two forms. These are preventative controls in the form of taxes or the prohibition of financial capital outflows. This control may help reduce the probability of speculative attack in the short run. Control of the capital outflow used by Latin American countries in the past according to Edwards (1999) was ineffective due to the ability of the private sector to evade controls and the ability to delay and adjust the public policy to fix the balance of payment disequilibrium.

The second form of control is the temporary imposition of control on financial capital outflow during a financial crisis and after devaluation such as in the case of Malaysia in 1998/1999. These measures may delay needed reform and did not stop or slow down financial capital flight in Mexico, Argentina, Brazil, and Peru during the 1980s. Chile, Brazil, Columbia, and Malaysia used control of capital inflows to achieve stability and growth. While Chile had no control over the movement of profit out of the country, it used financial capital inflow control during 1978-82 and 1991-98 periods. Chile’s basic control mechanism was reserve requirements on short term capital inflows and interest free reserve deposits on short term financial capital inflows. Also, direct foreign investment before 1992 had to stay in the country for three years. In 1992, this was changed to one year. The private sector found ways to reduce the impact of these regulations by mislabeling the purpose of inflows into trade credits or loans. The interest-free reserve deposit is similar to a tax on financial capital inflows. This implicit tax rate has a negative relationship with the length of time the fund stayed in the country, a positive relationship with the required rate of interest free-reserve deposits and a positive relationship with interest rates outside of the country as a measure of opportunity cost. According to Edwards (1999), the ability of the Chilean government to control financial capital inflow did not reach more than 80% at its best time but did reach a substantially lower percentage of controlling financial outflow. The purpose of Chilean financial control inflow was to reduce the risk of financial instability by reducing the rate of local currency appreciation due to financial capital inflow, increase the percentage of the funds inflow toward longer maturities, and keep interest rates in Chile different from that of international rates in order for Chile to have their own independent monetary policy. According to Edwards (1999), capital inflow controls did not have any impact on the appreciation of the currency in the long run but had an insignificant impact in the short run. But the controls were effective in increasing the ability of the central bank to follow more independent monetary policy. The negative impact of financial capital inflow controls was the higher cost of interest for Chilean firms, especially small and medium sized firms, due to their inability to evade these controls. Chile’s restrictions on capital inflows were not effective in avoiding the currency crisis of 1981/82 because of poor banking regulations. Financial capital inflow control may help the country avoid small external shocks, but not large shocks. Free financial capital movements should be introduced gradually at the end of market reforms and after sound financial market regulations are in place.

Short-term borrowing produces considerable hardship under free movement of financial capital. Usually, before the IMF will grant loans to a country in financial crisis, the country is required to raise its interest rates to reverse the financial capital outflow. This rise in interest rates pushes local firms with debt to sell their already undervalued domestic assets in a fire sale to foreign firms. These assets are undervalued because of a lack of credit. One would argue that allowing foreign firms to buy local assets during financial crisis and credit crunch is the wrong policy for a country to follow. Also, financial crisis could cause the country to lose its economic independence to the IMF. The cost of potential financial crisis due to the adoption of free mobility of financial capital has to be weighed against the potential benefit.

Recommendations

The government’s ability to deal efficiently with financial crisis can be improved by establishing an effective regulatory body in order to reduce high-risk lending practices of financial institutions. An effective regulatory body alone will not be sufficient to deal with financial crisis. Providing liquidity by IMF would prevent contagion and speculative attacks, but may increase the risk-taking of financial institutions without the proper regulatory body. If the IMF becomes the lender of last resort, then local authorities may have fewer incentives to create strong financial regulatory bodies since local authorities do not have to pay the full cost of the financial crisis. The current system of constructive ambiguity prevents local authorities from creating intentionally weak regulatory financial bodies. Also, the risk-based system of contribution by countries to IMF may help alleviate the problem of weak financial regulations.

Bail-out banks that are solvent but illiquid may prevent wider financial panics that destroy viable banks. Creditors need to be concerned and need to help developing countries in protecting potential productive investment projects from being halted during a financial crisis. Also, creditors need to help provide liquidity to meet short term obligations and help reschedule the debt.

Keeping proportion of short term financial capital inflows in non-interest bearing accounts for a given period of time or imposing taxes on the financial inflows or both represent high cost for short term financial inflows, but small costs for long term financial investment. The above two methods of regulation may help prevent local financial institutions from relying too heavily on foreign financial capital inflows to fund long term local lending, which is one of the reasons for financial crisis.

Limiting the percentage of long-term loans granted and held by local financial institutions to a level is helpful in preventing speculative currency attack. The above restriction does not eliminate financial crisis but may reduce its probability. Still, the major reason for financial crisis is the mismatch of maturity. The heavy reliance of local banks on rollover short-term foreign funds and the reliance of local corporations on borrowing from abroad on loans denominated in foreign currency would be a recipe for disaster if capital inflow reverses direction. Building up large amounts of foreign reserves, as in the case of China and Taiwan, makes a country less vulnerable to speculative attack. But the problem facing most developing countries is the lack of ability to do so.

Allowing foreign banks to operate in the developing countries may reduce the cost of the bail-out of the local banks in the event of a financial crisis. But the local depositors in foreign-owned banks would suffer without a bail out of the branches of foreign banks. Caprio and Honohan (1999) argued that opening the banking sector to foreign participation would increase the safety of the local banking sector. They gave New Zealand and Argentina as examples of the success of the financial liberalization. Unfortunately, Argentina in late 2001 and early 2002 had a financial crisis. Also there is a realistic fear that foreign banks may not lend money to needy small businesses. Developing countries need to encourage their banking to expand beyond their borders. This expansion may reduce the uncertainty associated with their small economy. However, this expansion of local banks beyond one country may reduce the volatility of the banking sector; it can also create exchange rate risk.

To reduce liquidity problems, the central banks may require high liquid reserve in the form of higher required reserves, low risk assets, and cash. Higher required reserves would reduce banks’ return on deposits, would reduce the risk of the banking sector and would cause the loss of some of the local deposits to the banks abroad. Argentina imposed high liquid reserves that protected its banks in 1997-99 but failed to protect its banking sector in the 2001-2002 period.

Tax on capital inflows to reduce speculations, interest rate ceilings on deposits to reduce competition by risky banks to attract deposits, and limits on the percentage of lending to the real estate sector would reduce the probability of having a financial crisis. Finally, redirecting financial capital inflows toward direct investment and equity finance and away from debt financing will serve developing countries better in the long run. Also redirecting finances will reduce liquidity problems and potential financial crisis.

Conclusion

The current account deficits and the lending expansion by local banks that are financed by financial capital inflow, a deterioration of financial institutions’ balance sheet, short term debt repaid in foreign currency, and speculative attacks appear the culprits behind financial crises. The expansionary monetary policy used by advanced industrialized economies in dealing with banking instability or stock market crashes is not a viable option for the central banks of developing economies. Direct financial capital flow toward direct investment and a way of debt financing combined with the proper amount of regulations for each country capital account and financial institutions may help reduce the recurring financial crises.

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